Monday, April 25, 2011

QE2 is Irrelevant

How can government policy make us better off? To bring about a welfare improvement, there must be some collective action we can take through our government that cannot be replicated by the private sector. The government must have some particular advantage in the activities it chooses in order to be doing anything useful. If the government is bad at running coal mines, it should let private firms run coal mines, and if the government is a bad banker, it should stay out of the banking business. However, we know that the government has an advantage in doing some things. For example, I think we can all agree that the government has an advantage in running the army.

If the government is no better or worse than the private sector in some activity, then if the government engages in more of that activity this is irrelevant. The government's activity simply displaces the same private activity one-for-one. If the government and the private sector have exactly the same technology for producing coffee cups, the government cannot increase the supply of coffee cups by producing more, unless it drives the private sector producers out of business. This is essentially the basis for all the government neutrality theorems we know about. For example, the Ricardian equivalence theorem states that, if the government and the private sector are equivalent in terms of their ability to collect on their debts, then the timing of taxation does not matter. Less government saving is undone by more private saving. The Modigliani-Miller theorem in corporate finance works in the same way. A firm's financing decision is irrelevant because it is undone by asset-holders, under certain conditions.

Central banks were established because there was some consensus that the government (or quasi-government) has an advantage in supplying currency, and in running intraday payments systems. Economists sometimes question whether monetary systems could be designed where one or both of these functions could be carried out efficiently by the private sector, but those ideas have never gathered much steam in public policy debate. In the United States, the Federal Reserve System has an essential monopoly (with the odd insignificant exception) on the issue of circulating small-denomination securities (currency), either through an implicit prohibition on private note issue, or because the issue of private currency is unprofitable. The Fed also dominates intraday payments arrangements among financial institutions. The clearing and settlement of large-value payments is accomplished mainly through the exchange of reserve account balances.

Ignoring payments systems issues for simplicity, the Fed's typical actions matter because of its monopoly on currency issue. In normal times, excess reserves are essentially zero, and a swap of reserves for Treasury bills by the Fed effectively increases the stock of currency (a Fed liability) while increasing the stock of T-bills on the asset side of the Fed's balance sheet. The Fed, being a large intermediary that can do something the private sector cannot, can thus move market asset prices, in particular the overnight market interest rate - the fed funds rate.

Now, since November, the Fed has been engaged in something unusual - QE2 - which essentially involves swaps of interest bearing reserves for long-maturity Treasury bonds. In spite of what Ben Bernanke might lead you to believe, this is not business as usual. This is not about issuing currency to finance the purchase of T-bills. What is going on then? The Fed is financing a portfolio of T-bonds by essentially rolling over overnight debt. That's what the reserves are under the current circumstances. The marginal unit of reserves does not serve any transaction role in the payments system. It just sits overnight.

Now, this type of intermediation bears a striking resemblance to what Gary Gorton's "shadow banks" do. Shadow banking is about holding long-maturity assets (could be asset backed securities, but long Treasuries certainly work), financing these asset holdings with overnight repos (with the assets used as collateral), and rolling over the repos. The Fed does not put up any collateral to the holders of reserve accounts, as apparently these financial institutions think that the Fed will always be good for it. The Fed has never suspended withdrawal privileges (conversion to currency) on its reserve accounts, for example.

Thus, QE2 is essentially shadow banking and, as such, it is an activity replicated in the private sector. Thus, QE2 is irrelevant. But, you might argue that shadow banking is a risky activity. This intermediation activity involves borrowing short and lending long, so maybe if the Fed does less of this, displacing an equal quantity of private intermediation activity, then this will transfer risk from the private sector to the Fed. Not so fast. The Fed cannot take risk off the private sector's hands in this manner. Should short rates increase (under the Fed's control of course), then the Fed will earn less profits, and pass on less to the Treasury, which then has to deal with it. The Treasury is no better equipped to share this loss among private economic agents than is the private sector.

What does this imply for current Fed policy? The Fed essentially has the same tool it always has for implementing monetary policy. While Fed policy is usually characterized in terms of the fed funds target rate, now the relevant policy instrument is the interest rate on reserves (IROR). The Fed has all the control over policy that it needs by manipulating the IROR.

Normally, as the economy recovers, the Fed needs to tighten, by increasing the fed funds rate target so as to control inflation. The Fed could always keep the fed funds target rate low during the recovery, but this would necessitate open market purchases to support the low target, which would be inflationary. Under current circumstances, if the Fed remains passive while the economy recovers, by keeping the IROR at 0.25% for an "extended period," then as the private sector creates more assets that can be intermediated and transformed into liquid tradeable assets, this will displace reserves, and ultimately lead to increases in the price level and an increase in the stock of currency. Just as in normal times, the Fed's policy rate must increase to choke off the inflation.

The good news here is that, since QE2 is irrelevant, the Fed can reverse it without cost. Ideally, the Fed should sell enough assets to reduce excess reserves to zero, so as to be back in a regime that it understands better. Given the state of the Fed's balance sheet, this cannot be done by just selling Treasury bonds, as T-bond holdings are currently at about $1.3 trillion, while the quantity of reserves outstanding is about $1.5 trillion. Selling all of its agency securities (essentially identical to Treasuries) still will not quite do it (that gives another $130 billion), so the Fed would have to dispose of a relatively small quantity of mortgage-backed securities.

Now, some people will suggest that empirical evidence contradicts what I have just stated. If QE2 was irrelevant, what about those asset price movements that coincide with the QE2 announcements? Those effects are consistent with my story, in that the QE2 announcements carried news about the future path for the policy rate. Essentially, QE2 suggested something to financial market participants about the length of the extended period with the IROR at 0.25%. Clearly it could not have been a commitment device (except perhaps because the Fed does not like to admit mistakes), as reversing QE2 is irrelevant.

The implications of this for current monetary policy are fairly dramatic. Bernanke would have to admit that previous policy decisions were wrongheaded (though not necessarily disastrous), but that certainly beats living a lie. He would also have to accept that all his talk about the array of policy instruments at the Fed's disposal is smoke and mirrors. Quantitative easing is a sham. Term deposits can at best serve to make reserves less liquid, and therefore more costly for the Fed, as they will need to command a higher interest rate than the IROR. Reverse repos are irrelevant. Do you think the Fed will admit to its errors? I doubt it.

28 comments:

"The Treasury is no better equipped to share this loss among private economic agents than is the private sector."

How do you know?

Perhaps the view is that the Fed or the Treasury does have a better ability to bear risk than the banks which were previously engaged in shadow banking activity? I am thinking here in a model where there are agency costs to borrowing and where institutions that normally engage in shadow banking have reasons to be worried about ratcheting up these costs by borrowing too much. This is not to say that the Federal government should not worry about that as well, but isn't it plausible to think that it is further away from that point? Also, the special ability to tax and ultimately inflate the price level makes it virtually impossible that the Fed or the federal government would default on an overnight claim.

It hasn't taken over insurance companies, but it provides a lot of insurance. Insurance for health, old age, disability, unemployment, flood, the death of a spouse or parent, and more are all provided by the federal government.

"If QE2 was irrelevant, what about those asset price movements that coincide with the QE2 announcements? Those effects are consistent with my story, in that the QE2 announcements carried news about the future path for the policy rate."

I think that you are reaching, Steve. But I am glad to hear the arguments.

First, Macro Advisors' bulletins (Meyer and Bomfim) tried to explain long-term interest rate movements during QE with OIS spreads, which proxy for expected funds rate over a long period. As I recall, they had only very modest success.

Second, you know that changes in expected fed funds rates don't consistently affect long-rates because there are contradictory effects. The first rounds of QE announcements did affect long-rates consistently.

Even if you are correct as to the mechanism through which QE lowered long rates, so what? Real long rates were still lower and that changed people's real choices.

"Without a theory, you can't organize any of the observations you are talking about. Staring at the time series won't do it."

If I was not so insensitive, you would have hurt my feelings.

Here is my theory: If the Fed has the power to change real asset prices, then it has the power to change real activity.

I will have to consult my favorite macro text, Williamson, to determine the most likely manner in which those real asset price changes affect the real economy. But I am pretty sure that I can come up with a theory that says that changes in real asset prices can affect the real economy. In fact, I suspect that I would have to search hard for a non-trivial macro theory that implied the opposite.

1- There is if this is not all you are doing. I guess you are saying that, in principle, you could set up a perfectly transparent fund that mechanically borrows overnight and buys treasuries and commits not to do anything else. What you seem to be saying is that the costs of setting up such a fund are not worth the expected returns and, implicitly, that the costs are small enough that the government (who does not need to set this up) does not have enough of a margin to affect. I'll take the point, although this is to some extent an empirical matter. How many basis points does such a fund need to make in order to be profitable? How many basis points does QE2 need to be able to move the interest rate around in order to be successful?

2. The government does not have much of an advantage when it comes to idiosyncratic risk, these can be readily diversified. Many people do argue that there is a role for government in re-insurance, where aggregate risk plays a larger role.

"What you seem to be saying is that the costs of setting up such a fund are not worth the expected returns"

No, I'm saying the Fed has no advantage in setting up such a fund. The Treasury bonds serve as collateral for the repos, so there's no agency problem.

On the insurance: I suppose we think that the government has some advantage in providing some kinds of insurance - unemployment insurance for example, though it's a bit difficult to write down the model that delivers this.Suppose that the government has already solved all these problems, say including using the tax system as a social insurance scheme. It then seems far-fetched that there is some insurance role that works specifically through this Fed maturity transformation. Somehow the private sector can't intermediate across maturities efficiently, and share the risk, but the Fed and the Treasury can?

There are two ways to lend money. In one, I lend you money and trust that you value your reputation enough to pay me back. I know how much you owe people, but I don't micromanage how you use the money I lend you. Specifically, I cannot verify that you are indeed using the money I lend you short term to buy treasuries and only treasuries. This form of lending works fine so long as your debt is not too big relative to your verifiable assets and revenues.

In the second form, I do micromanage what you do. I force you to set up accounting practices and I send people to monitor you. By doing this I ensure that you only do what I think is a sound investment. But I have to expend resources to make you do that.

What I am saying is that right now the government has a comparative advantage in the first form of intermediation. This may not amount to much if the setup costs needed to make the second one work are negligeable. But this is an empirical matter.

As for the government having already solved all these insurance problems, arguably it had before the crisis, but now it needs to re-optimize. Being the government it does this slowly and haphazardly. This means that, two and a half years afterwards there might be still some margins left to be adjusted.

This is like the rationale for deposit insurance. It's very costly for the individual depositors to monitor the banks, and sometimes the depositors get it wrong and we have disruptive runs on otherwise sound banks. So we have deposit insurance, and we have the deposit insurer watch the banks to make sure they do not take on too much risk. Now, we all know where that went. Sometimes the regulator is not doing its job properly. Sometimes the government thinks that the banks are too big to fail and bails them out, and so does not solve the moral hazard problem. I'm not sure that there is necessarily an advantage for the government here. Maybe there are good governments and bad governments, or good regulators and bad regulators. But how do we discipline them?

You are saying that, normally, at the margin, the cost of disciplining the government is not smaller than the cost of disciplining a bank. What I am trying to argue is that while this may be true in steady state (after everyone has optimized), this is less likely to be true after a crisis that destroyed much of the collateral that the private sector relied on to provide discipline. To the extent that the government has not lost as much, re-optimization involves increasing the government's participation at least until the private sector is back to its previous form.

You may have good reasons to disagree with this view. The government has already done a lot, and has also lost a lot of reputation as we see from the current discussions about the national debt and perhaps the potential gains are quantitatively small. But it is not an irrelevance theorem. It is an empirical matter about which, lacking better data and appropriate counter-factuals, reasonable people can disagree.

Yes, there is theory, and then there is empirical work. Still, I think what you are discussing is a fiscal policy issue. The private sector in part produces assets that are used in financial trade, and the shadow-banking intermediation is an important part of how the financing of economic activity works. Temporarily destroy part of the private sector's capacity to produce these assets, and the government can step in to make up the difference - temporary tax cut, float more debt, raise taxes later and retire the debt. I don't think this has anything to do with the maturity structure of the government debt held by the private sector vs. the Fed.

I don't have a copy of Chris's favorite macro text, but certainly it's hard to argue that there is not an abundance of theoretical work which posits a 'channel' through which real asset prices affect the real economy. Among many others, see Blanchard (JPE, 1985), Bernanke and Gertler (AER, 1989), and Kiyotaki and Moore (JPE, 1997).

Yes, there are plenty of channels for monetary policy, that work through credit and the intermediation sector. I work on them myself - see my 1987 JPE paper and my recent work, for example, as well as my favorite textbook. QE2, however, is not one of those.

"The Fed does not put up any collateral to the holders of reserve accounts, as apparently these financial institutions think that the Fed will always be good for it."

The Fed doesn't have to put up collateral because it already accepted collateral when the reserve account was created. For instance, if reserves were created by open market operations, these reserves were effectively exchanged for what was to become their collateral security; t-bills. When the reserves are cancelled the collateral returns to its holder. Reserves are well-backed and collateralized.

" Under current circumstances, if the Fed remains passive while the economy recovers, by keeping the IROR at 0.25% for an "extended period," then as the private sector creates more assets that can be intermediated and transformed into liquid tradeable assets, this will displace reserves, and ultimately lead to increases in the price level and an increase in the stock of currency."

How will the creation of tradeable assets displace reserves? Banks don't lend from their reserve accounts at the Fed, after all. To my knowledge the only way to displace (destroy?) reserves are for banks to convert them to cash, or the Fed to cancel reserves through open market operations and the return of collateral assets.

What is the contract between the Fed and a financial institution with a reserve account? The contract does not specify any collateral. It only carries with it a promise to pay currency on demand. The Fed's ability to do that depends on the assets it holds, and the Fed makes no commitments about what those assets are. As we have seen recently, all kinds of weird stuff can end up on the asset side of the Fed balance sheet.

The second thing just comes from an equilibrium relationship.

"To my knowledge the only way to displace (destroy?) reserves are for banks to convert them to cash"

The contract is specified in the Federal Reserve Act, Sections 13, 14 and 16 among others. The fine print specifies the sorts of collateral permitted. For instance, equity cannot serve as collateral for Federal Reserve credit. There is a fairly long history behind approved collateral... at the beginning only gold and short-term commercial credit were eligible but obviously this has changed over the years.

The collateral works the other way. When the Fed lends to financial institutions at the discount window, it asks for collateral. When the financial institutions lend to the Fed by holding a reserve account, the financial institutions don't ask for collateral from the Fed.

"The Modigliani-Miller theorem in corporate finance works in the same way."

Yeah but it's well understood and accepted in finance that MM is just a starting point. It doesn't actually work that way at all in the real world because of big violations of the underlying assumptions, like transactions costs, financial distress costs, illiquidity, bankruptcy costs, tax laws, and asymmetric information. this is always taught in first year PhD finance classes (as well as MBA and BA). You always go through, now see how it changes when we add financial distress and bankruptcy costs, next when we add taxes,...

Are you sure that there aren't gross violations of the assumptions behind your argument that make it very untrue in the real world?

QE2 is irrelevant only to the extent that private sector agents have the same information and preferences as the Fed and as one another. But in fact they have neither.

1. The Fed almost certainly has better information about its own future policy intentions than the private sector does. As you say, "the QE2 announcements carried news about the future path for the policy rate." I don't see how this is consistent with the view that QE2 is irrelevant. You might argue that it is not the most efficient way to communicate the news, but I'm not so sure. The news may be too vague and complex to convey easily in words, and even if it could be conveyed, it might not be credible. Although you argue that the reversal of QE2 is irrelevant, this is not so from the point of view of the Fed's profitability. The Fed is taking a risk whose outcome depends on its own future policy actions, just as a private sector agent that undertook similar maturity transformation would be taking a risk. Since the Fed controls its own policy, its willingness to take that risk conveys credible information about its intentions.

2. Because private sector agents have heterogeneous opinions and preferences, the supply curve for maturity transformation is upward sloping. An agent with a weak opinion, for example, will abandon its position if it receives slightly better terms; an agent with a strong opinion will hold its position despite being offered much better terms. A very large agent, such as the Fed, that undertakes a large scale asset purchase in this environment, will not be a price-taker. Rather, its action will shift the supply curve and change the price. Thus even apart from the signalling effect, QE2 has an impact on asset prices (just as a comparably sized private sector institution would have an impact if it had a dramatic shift in its opinion about the future path of interest rates).

Ok, not to be picky, but I think I've found a glitch with your analogy:

"What is going on then? The Fed is financing a portfolio of T-bonds by essentially rolling over overnight debt."

The Fed is buying T-bonds outright, not borrowing them. In return it is issuing reserves. But these reserves are themselves perpetual instruments; they cannot be destroyed by their holder. (They can be turned in for cash, but cash is also a perpetual instrument). Thus there is no explicit problems with rollover and ongoing financing - the Fed has secured "eternal" financing.

I thought quantitative easing was the Fed's purchase of those toxic mortgage-backed securities from financial institutions. Your description of QE2 (swaps of reserves for t-bonds) sounds like ordinary open market operations to me. Where am I going wrong?

"When the financial institutions lend to the Fed by holding a reserve account, the financial institutions don't ask for collateral from the Fed." They don't need to ask for collateral, because the default risk is zero. The FED (as well as any other central bank) will always be able to repay in its home currency ... with the only exception when they run out of paper and color to print new money.